Mergers & Acquisitions

The Data Room

The Electronic Data Room

The electronic data room is built around the same concept as the physical data room,
where the information requested by due diligence teams is stored in one place. The
difference is that the “place” is a secured website. This is extremely convenient for
bidders, who no longer have to send employees and other investigators long
distances for due diligence (though more in-depth analysis of facilities, as well as
employee interviews, will still require on-site visits). The added level of
convenience may even attract more bidders who would otherwise not be willing to
send in a team for an initial review of the business. This approach also works well
for those sellers that do not want to maintain a physical facility and related security
systems for their due diligence documents.

A seller could set up its own electronic data room, but it would not contain a
variety of security and other features included in the offerings of several third-party
providers. Consequently, it is customary to pay a third party for this service. When
looking to rent an electronic data room, consider the following features and services:

• File formats. All file formats should be allowed for storage. At a minimum,
it should be possible to store Excel, Word, and PDF files. Also, there should
be no limit on the size of files.

• File structure. The site should allow the seller to set up a coherent subdirec-
tory structure into which documents can be stored, where there is no limita-
tion on the number of subdirectories. For example, the file structure might
include subdirectories for the following types of information:
o Employees
o Financial statements
o Intellectual property
o Legal issues
o Licenses and permits
o Organizational information
o Products
o Real estate
o Sales documentation
o Tax returns

It should also be easy to move files from one subdirectory to another within
the file structure.
• Hosting. The site should store data on its own servers, rather than on the
servers of a third party where it would be easier for a someone to hack into
files.
• In-house uploading. If the seller elects to have the data room provider scan
documents and upload them to the site, the provider should use its own staff
to do the scanning. Outsourcing this work presents the risk that a third party
will gain access to the seller’s confidential documents.
• Print control. The site should allow the seller the ability to restrict a user
from printing a document.

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• Reporting. The provider should have a reporting system in place that reveals
which documents have been viewed, who viewed them, when they were
viewed, and for how long each document was viewed.

• Security. The site must require password access, and may also require
additional access to certain parts of the site. For example, someone identi-
fied as an accountant might only be given access to the financial statements
and supporting documents, while someone else identified as an attorney
might only be allowed access to legal documents.

• Security certification. Have the site show proof that a security review of it
was conducted recently by a third party.

• Speed. It should be possible to set up a site in just a few hours, though the
associated training required to administer the site may extend the initial set
up period.

• Support. Due diligence reviews are famous for going on through the middle
of the night, as well as weekends and holidays. That means any issues with
the electronic data room must be resolved at once, at any time of the day or
night.

• Training. There should be on-line training available for any employees who
need to learn the functionality of the site, as well as a help desk to assist
with any problems found.

• Uploads. The site must allow the seller’s staff to scan all documents and
efficiently upload them into the site.

• Watermarking. Some sites incorporate a watermark in documents, which
prevents anyone from printing documents or taking screen shots without the
revealing watermark.

The preceding list of desired features is heavy on security, since a key concern of
any seller is to keep its confidential information from being scraped from the site by
a competitor. The seller should peruse the reports provided by the site manager to
see if anyone is downloading large volumes of material, and then decide if that
entity’s user access should be denied to keep too much material from falling into the
wrong hands.

Tip: The reporting features of an electronic data room are of particular interest,
since the seller can use it to see if different people from a particular bidder are
sequentially reviewing documents. This is a sign that the seller passed an initial
review, at which point a different set of reviewers were tasked with another tranche
of review activities.

The typical pricing structure for an electronic data room is a one-time fee to initially
set up the site and load documents, followed by a monthly storage charge for
however many months the seller needs to keep the information available during the
auction process. Any user should expect to spend at least $10,000 for an electronic
data room, with the price increasing in proportion to the number of documents

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The Data Room
stored on the site and the time period over which the documents are stored. The cost
per page stored declines as the number of pages increases, but expect to pay at least
$1.00 per page with the initial setup of the site. This price increases substantially if
the seller wants the site provider to also scan and upload its due diligence
documents.
Tip: If the seller has engaged the services of an investment banker to assist in the
sale, the banker may have experience in setting up the structure of an electronic data
site, and may even assist with uploading documents to it. This can increase the
rollout speed for the site.
Summary
For larger transactions, the electronic data room has become the information
distribution system of choice. This does not necessarily mean that the physical data
room has been completely supplanted – far from it. The operators of electronic data
rooms charge relatively high prices for their services, so a smaller company that is
likely to have mostly local bidders can get by quite cost-effectively with a physical
data room. However, the key point is that any auction-style selling environment
must have either type of data room; dealing with individual due diligence requests is
far too time-consuming for the selling entity.

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Chapter 6
Valuation of the Target

Introduction

There are many ways to value a business, which can yield widely varying results,
depending upon the basis of each valuation method. Some methods assume a
valuation based on the assumption that a business will be sold off at bankruptcy
prices, while other methods focus on the inherent value of intellectual property and
the strength of a company’s brands, which can yield much higher valuations. There
are many other valuation methods lying between these two extremes.

We need all of these methods, because no single valuation method applies to all
businesses. For example, a rapidly-growing business with excellent market share
may produce little cash flow, and so cannot be valued based on its discounted cash
flows. Alternatively, a company may have poured all of its funds into the
development of intellectual property, but has no market share at all. Only through
the application of multiple valuation methods can we discern what the value of a
business may be.

In this chapter, we cover how to arrive at a valuation. You will see not only the
calculation methodology, but also the assumptions underlying each one, and the
situations to which they might be applied. They are presented beginning with those
likely to yield the lowest valuations, and progress through other methods that usually
result in higher valuations. The methods are summarized at the end of the chapter, in
the Valuation Floor and Ceiling section.

Related Podcast Episode: Episode 75 of the Accounting Best Practices Podcast
discusses acquisition valuation. You can listen to it at: accounting-
tools.com/podcasts or iTunes

Board of Directors Liability

The board of directors of any company has a fiduciary responsibility to its
shareholders to obtain the highest possible return on their investment in the
company’s shares. This means that, if the company receives a purchase offer, the
board should spend sufficient time examining the bid and weighing it against other
offers and the advice of experts to reasonably ensure that shareholder return is being
maximized. If the board does not engage in this level of due diligence, it runs the
risk of being sued for negligence by the shareholders for having accepted an
inadequate offer.

Given the liability of the board of directors, they should be aware of the
valuation methodologies outlined in the remainder of this chapter.

Valuation of the Target

Timing of the Deal

The following sections contain a broad array of methods used to derive the valuation
of a target entity. What they do not mention is that the date on which a valuation is
calculated can have a profound impact on the valuation. Most acquisitions are
completed during an upswing in the market, when the results of acquirees are
unusually good, acquirers have accumulated some cash for purchases, and lenders
are more willing to advance funds for an acquisition. During these times, the
valuation of an acquiree may be inordinately high in comparison to how it was
performing at the previous low point in the business cycle. If an acquirer completes
an acquisition at this time, the price paid may be so high that it will be quite difficult
to produce enough cash flow from the deal to ensure that it pays off in the long run.

Given this timing issue, it makes more sense to engage in acquisitions during the
depths of the business cycle, when acquirees cannot point to outlandish financial
results to justify high valuations. If an acquirer can complete a deal at these lower
valuation levels, the risk of overpayment is low. However, the goal of only buying in
a down cycle is not easy to achieve, for several reasons:

• Financial discipline. An acquirer must pile up a large amount of cash during
high points in the business cycle, in order to have the financial wherewithal
to snap up companies in the depths of a downturn.

• Ego. Some company presidents love to publicize their acquisitions, and the
resulting increase in size of the businesses they control. Buying in a down-
turn requires the patience to wait for the right deal at the right price, and
walking away from everything else. Many presidents do not have the forti-
tude to do so.

• Willing lenders. Lenders typically tighten their lending standards during a
downturn, so it can be difficult to obtain debt financing for an acquisition.
This makes it even more imperative to maintain a large cash reserve.

• Willing sellers. The owners of a business should be unwilling to sell during
a downturn, since they know the valuation they receive will be substandard.
Consequently, a prospective buyer may find that only the financial weak-
lings in an industry, which are teetering on the edge of collapse, are willing
to sell out. Conversely, this also means that the most robust competitors will
see no need to accept a low-ball offer, and so will not be available for sale.

Despite the difficulties inherent in making a downturn-oriented strategy work, an
acquirer can conclude deals at a fraction of what they would have paid at the peak of
the market.

EXAMPLE

Global Camper, Inc. produces mid-sized motorhomes for campers in North America and
Europe, with an emphasis on reasonable pricing. Global is parked in the middle of the
market, scooping up roughly 50% of all industry profits. The motorhome market is
comprised of a few larger producers and many smaller manufacturers that specialize in niche

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products. Global has a standard acquisition strategy of maintaining large cash reserves,
which it employs to buy smaller competitors with all-cash offers during periodic industry
downturns.

If a business broker ever approaches Global with an offer from a seller that is excessively
high, the acquisitions manager immediately turns down the deal and puts the seller on her
watch list, to see if its prospects decline over time. If so, Global extends a lower offer. If the
seller rejects the offer, the acquisitions manager is content to wait and see if the business
enters bankruptcy, in which case Global may make an even lower-priced offer.

A key competitor, High-Line Camper, has stolen away a number of deals from Global by
offering higher prices to sellers. High-Line has been able to do so by financing its acquisition
spree with low-cost debt. Global bides its time and waits for interest rates to rise; when they
do so, High-Line cannot pay off its debt, and Global buys the company out of bankruptcy,
along with all of the companies that High-Line had previously acquired.

Liquidation Value

Liquidation value is the amount of funds that would be collected if all assets and
liabilities of the target company were to be sold off or settled. Generally, liquidation
value varies depending upon the time allowed to sell assets. If there is a very short-
term “fire sale,” then the assumed amount realized from the sale would be lower
than if a business were permitted to liquidate over a longer period of time.

The liquidation value concept is based on the assumption that a business will
terminate, for one that continues in business has additional earning power from its
intellectual property, products, branding, and so forth. Thus, liquidation value sets
the lowest possible valuation for a business. The concept is useful for the acquirer to
address even in cases where it intends to pay a great deal more for a target company.
The reason is that the difference between the liquidation value and the amount
actually paid is the amount for which the acquirer is at risk, in case there are
problems with the target company that require it to be liquidated.

The owners of a business would be foolish to sell at the liquidation price, since
they could just as easily liquidate the business themselves as sell it to someone else
and have them liquidate it. Nonetheless, if a business is suffering from any number
of factors related to its operations or the business environment, it is possible that an
astute acquirer might actually complete a purchase at a valuation relatively close to
the liquidation value of the target.

Real Estate Value

If a company has substantial real estate holdings, they may form the primary basis
for the valuation of the business. This approach only works if nearly all of the assets
of a business are various forms of real estate. Since most businesses lease real estate,
rather than owning it, this method can only be used in a small number of situations.

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EXAMPLE

High Noon Armaments is interested in acquiring Home Caliber, a chain of gun shops. Upon
further investigation, High Noon finds that the shops are barely profitable, but that Home
Caliber owns both the land on which its stores are situated and the stores themselves. The
CFO of High Noon elects to compile a valuation based on the underlying real estate, rather
than the cash flow fundamentals of the business.

If the acquirer has no experience in dealing with real estate, and plans to sell off the
real estate, then it may apply a discount to the real estate values that it derives.
However, since the real estate valuation is being used as the primary source of
information for the valuation, and the acquirer expects to sell the real estate, this
brings up the issue of why the acquirer is making an offer at all.

From the perspective of a seller that wants to be sold, it may make more sense to
gradually sell off the real estate in such a manner as to maximize prices, and use the
funds to either buy back shares or issue a large cash dividend to shareholders. This
approach shifts all of the cash directly to the shareholders, without worrying about
any discount that might be applied by a prospective acquirer. Company management
can then pursue the sale of the remainder of the business to realize any residual cash,
which also goes to the shareholders.

Relief-from-Royalty Method

What about situations where a company has significant intangible assets, such as
patents and software? How can a valuation be created for them? A possible approach
is the relief-from-royalty method, which involves estimating the royalty that the
company would have paid for the rights to use an intangible asset if it had to license
it from a third party. This estimation is based on a sampling of licensing deals for
similar assets. These deals are not normally made public, so it can be difficult to
derive the necessary comparative information.

Under this method, any savings from not licensing an asset are considered on an
after-tax basis. The reason is that, if the company had indeed licensed the rights
from a third party, there would have been a licensing expense that reduced taxable
income.

The relief-from-royalty method is hardly one that can be used to value an entire
enterprise, since it only addresses intangible assets. Nonetheless, it is one of the few
methods available for putting a price tag on intangible assets, and so can be of use in
situations where intangibles comprise a large part of the assets of a target company.

Book Value

Book value is the amount that shareholders would receive if a company’s assets,
liabilities, and preferred stock were sold or paid off at exactly the amounts at which
they are recorded in the company’s accounting records. It is highly unlikely that this
would ever actually take place, because the market value at which these items would

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be sold or paid off might vary by substantial amounts from their recorded values.
There could be particularly large disparities between the recorded and market values
of items in the following areas:

• Inventory. If a company uses the last in, first out method of inventory
costing, this could mean that some portions of the inventory are assigned a
cost that could be a number of years old. Also, if a company is located in an
industry where inventory obsolescence occurs quickly, then the recorded
cost of inventory may be much higher than the amount at which it could
actually be sold.

• Fixed assets. Fixed assets are recorded at their purchase costs. That cost is
reduced over the useful life of the assets with depreciation. However, the
depreciation charge does not necessarily relate to the decline in the market
value of an asset over time. Instead, there can be a significant difference
between the net book value of a fixed asset and its sale price.

• Intangible assets. Intangible assets are recorded at their purchase costs,
which are then reduced over the useful life of the assets with amortization.
There can be very large differences between the market value of these assets
and their net book value. For example, a patent may have an increasing
market value that greatly exceeds its recorded cost.

• Contingent liabilities. There may be any number of contingent liabilities that
are not recorded in the accounting records of a business at all, and yet repre-
sent significant liabilities. For example, there may be a potential for adverse
judgments in lawsuits, or as a guarantor for a debt.

Book value is an imprecise measure of the value of a business, since it simply
reflects a variety of accounting standards used to record accounting transactions. It
does not necessarily reflect the value of a business at all. In general, it may be used
as a baseline around which more valid valuation results may fall.

Book value may also be used as the denominator in the calculation of sale price
to book value for the sales of similar businesses. Thus, if a mix of other companies
in the same industry sold for a multiple of five times book value, then one might
apply that same relationship to another prospective sale when determining a price
for it.

EXAMPLE

High Noon Armaments wants to determine the sales price to book value ratio for recent sales
in the armaments industry, to see what types of multiples it should apply when formulating
offer prices for other businesses.

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It compiles the following information about five other sale transactions that were completed
within the past 12 months:

Transaction Sale Book Sale-to-Book-Value
A Price Value Ratio
B $10,000,000 $3,800,000 2.6x
C 27,500,000 8,900,000 3.1x
D 42,650,000 10,900,000 3.9x
E 16,250,000 5,800,000 2.8x
6,500,000 4,800,000 1.4x
Totals
$102,900,000 $34,200,000 3.0x

Upon further examination of the underlying information, High Noon’s CFO finds that
Transaction E involved the sale of a business that was in severe financial difficulties, so he
throws out the outlier ratio that resulted from that transaction. The remaining transactions
yield an average sale-to-book-value ratio of 3.3x.

There are a number of problems with using the sale price to book value ratio as the
basis for a valuation. They are:

• Intellectual property. Another business may have garnered an unusually
high price in comparison to its book value, because it had unusually excel-
lent intellectual property that may not have even been recorded as an asset in
its accounting records.

• Early-sale effect. If there is a surge in acquisitions within an industry,
typically the highest-quality firms are snapped up first. This means that the
highest ratios of sale price to book value appear early in an acquisition cy-
cle; the ratio should decline later in the cycle, as lower-quality firms are
purchased.

• Asset efficiency. Some companies are much more efficient in the use of their
assets than others, leading to significant disparities in the ratio.

In short, book value is of dubious use in deriving the valuation of a target company.
You should certainly not use it as the sole basis for deriving a valuation.

Enterprise Value

What would be the value of a target company if an acquirer were to buy all of its
shares on the open market, pay off any existing debt, and keep any cash remaining
on the target’s balance sheet? This is called the enterprise value of a business, and
the calculation is:

+ Market value of all shares outstanding
+ Total debt outstanding
- Cash
= Enterprise value

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Valuation of the Target

Enterprise value is only a theoretical form of valuation, because it does not factor in
the effect on the market price of a target company’s stock once the takeover bid is
announced. Also, it does not include the impact of a control premium on the price
per share (see the Control Premium section). In addition, the current market price
may not be indicative of the real value of the business if the stock is thinly traded,
since a few trades can substantially alter the market price. Further, the removal of
cash from the target company does not indicate the need for that cash in order to
continue operating the target business. Nonetheless, enterprise value is of some use
in determining the “raw” valuation prior to estimating the control premium and other
factors that typically boost the valuation of a business.

EXAMPLE

High Noon Armaments is preparing the valuation of a target company, and the CFO wants to
know the amount of its enterprise value. The target has one million shares, and today’s
market price is $12.50 per share. According to its most recent quarterly Form 10-Q filing, the
target has $2.4 million of outstanding debt, and $200,000 of cash on hand. Based on this
information, its enterprise value is:

+ Market value (1,000,000 shares × $12.50/share) $12,500,000
+ Debt 2,400,000
- Cash -200,000

= Enterprise value $14,700,000

Multiples Analysis

It is quite easy to compile information based on the financial information and stock
prices of publicly-held companies, and then convert this information into valuation
multiples that are based on company performance. These multiples can then be used
to derive an approximate valuation for a specific company. The typical approach is
as follows:

1. Create a list of the top ten publicly-held companies most comparable to the
company for which a valuation is being compiled.

2. Find the current market valuation for each business, which is easily obtained
through Yahoo Finance or Google Finance.

3. Obtain the revenue information for the past 12 months for each business,
either from SEC filings or the Internet sites just noted. Compare revenues to
the total company market valuation to arrive at a sales-to-market-value mul-
tiple.

4. Obtain the EBITDA information for the past 12 months for each business,
either from SEC filings or the Internet sites just noted. EBITDA is earnings
before interest, taxes, depreciation, and amortization. It is a rough measure
of the cash flows of a business. Compare EBITDA to the total company
market valuation to arrive at an EBITDA-to-market-value multiple.

5. Multiply the target company’s revenue and EBITDA amounts for the past
12 months by the median multiples for the target group to derive valuations.

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The following example illustrates the concept.

EXAMPLE

High Noon Armaments routinely acquires other businesses within the firearms industry, and
so conducts an annual review of the revenue and EBITDA multiples associated with the
smaller publicly-held companies in the same industry. Accordingly, the acquisitions staff
prepares the following multiples analysis.

Multiples Analysis
Firearms Industry
As of January 10, 20xx

(000s)

Name Market One Year One Year Revenue EBITDA
Arbuckle Weapons Capitalization Revenues EBITDA Multiple Multiple
Billy the Kid Designs
Heston Shotguns $145,000 $174,000 $19,300 1.2x 7.5x
Patton Siege Guns 90,000 117,000 11,500 1.3x 7.8x
Plasma Weapons 160,000 24,200 0.8x 5.3x
Quigley Artillery 128,000 210,000 30,000 1.0x 7.0x
Rifled Custom Guns 210,000 3,900 2.2x 13.2x
24,000 42,400 1.5x 8.5x
Totals 52,000 240,000 3,200 4.0x 24.0x
360,000
19,000 $134,500 1.1x 7.9x
76,000
$944,000
$1,061,000

Thus, the review shows a weighted-average revenue multiple of 1.1x and a weighted-average
EBITDA multiple of 7.9x.

One month later, High Noon is engaged in a valuation analysis of a prospective acquisition,
which has annual sales of $6.8 million and EBITDA of $400,000. Based on the multiples
analysis, High Noon arrives at the following possible valuations for the company:

Target company results Revenue EBITDA
× Industry average multiple $6,800,000 $400,000

= Valuation based on multipliers 1.1x 7.9x

$7,480,000 $3,160,000

The results suggest quite a broad range of possible valuations, from $3,160,000 to
$7,480,000. It is possible that the target company has unusually low EBITDA in comparison
to the industry, which is causing its EBITDA-based multiplier to be so low. This means that
High Noon might want to push for a lower valuation if it proceeds with the acquisition.

It is most common to multiply the valuation multiples by the revenue and EBITDA
information for the target company for its last 12 months. This is known as trailing
revenue or trailing EBITDA. This is the most valid information available, for it
represents the actual results of the business in the immediate past. However, if a
target company expects exceptional results in the near future, then it prefers to use
forward revenue or forward EBITDA. These measurements multiply expected

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results for the next 12 months by the valuation multipliers. While the use of forward
measurements can create a good estimate of what a business will be worth in the
near future, it generally incorporates such optimistic estimates that it tends to result
in excessively high valuations.

Tip: If you allow a target company to derive its valuation based on forward revenue
or EBITDA, then insist that the target does so based on its internal budgeted
information for the projected period, and only if it has a solid track record of having
met its budgeted numbers in the past.

A multiplier analysis that is based on revenues is useful in cases where a business is
in high-growth mode, where there are typically fewer profits. This is because such
businesses have elevated expenditure levels to hire staff, acquire more facilities, and
other issues related to faster growth. However, creating a valuation based solely on
revenues is dangerous, since a target company may be generating those revenues by
selling at such rock-bottom prices that it will be impossible for the acquirer to turn a
profit. Also, high revenues do not mean that a business is being well run. In short, a
revenue-based multiplier should be supplemented by other valuation techniques.

The EBITDA multiple is a much better basis for a valuation than the revenue
multiple, since it reflects the ability of a business to generate a profit. However, you
should examine the EBITDA for the past few years as well, to see if the
management of the target company is cutting back on expenditures in the current
year in order to make the business appear more profitable.

Tip: Apply both the revenue and EBITDA multiples to each acquisition. If the
revenue multiple results in a lower valuation than the EBITDA-based valuation, then
the target company has higher profits than the average for the industry. The reverse
situation indicates lower-than-average profitability. In either case, the relationship
between the valuation levels can be used as the basis for additional due diligence.

There are several problems with multiples analysis to be aware of. They are:
• Company size. The information used for multiples analysis comes from
publicly-held companies, and those companies are generally larger ones.
Thus, the multiples that they command may not be applicable to smaller,
privately-held organizations.
• Conglomerates. If a target company dabbles in multiple industries, then it is
extremely difficult, if not impossible, to construct a multiples analysis for it.
This is a particular problem when a target company insists on a valuation for
the entire company that is based on the subsidiary located in an industry
where multiples are highest. Given the difficulty of analysis, it may be better
to use the discounted cash flows method instead (see the Discounted Cash
Flows section).
• Market capitalization. A very large publicly-held company may have higher
multiples than smaller companies, if only because it has a more liquid mar-

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